The third quarter is this continuation of second quarter, and the fourth quarter coming up is a continuation of third quarter. Much of that is a developing story – nothing dramatic in the sense that nothing completely stops or starts.
The bend and break idea revolves around the discussion we have been having since January this year when the Fed started talking about raising rates.
The discussion is, “Will it be a ‘soft landing’? Will it be a ‘hard landing’? Is it going to be bull in a China shop? Is it gonna break things, is it not?”
The original speculation was, “No, it will not be a ‘hard landing.’ We are just bending. The Fed is shaping the economy in certain way by raising interest rates.” That made sense at the time, but we were expecting change regarding transitory inflation, which was quickly proven not to be the case.
The Fed has been single-mindedly trying to stop the rise of inflation.
As the inflation continues to ratchet up, this bending becoming harder and harder because you’re trying to stop a moving train. The Fed began raising rates slowly and then decided, “No, no, no, that’s not working, or it’s not gonna work as quickly as we would like.”
The Fed proceeded to, what they call “front-loading.”
Front-loading means that the economy is well, unemployment is low, people are spending, so The Fed will take advantage of when the economy is doing well. Take advantage of the economy by doing what? By raising rates quickly. It went from 25 basis point to 50 basis point to 75 basis point per meeting. And now 75 basis points is the de facto way of increasing interest rates, which is a lot.
In the third quarter, we came to realize that the Fed is very serious in bringing the inflation rate back to their target 2%. We’re really talking about the core inflation rate, which is what they care about.
Core inflation rate is the inflation rate that is much stickier, it’s not up and down, it’s not very volatile. That’s the inflation that we live with. The Fed wants to make sure that inflation rate comes down to 2%. Right now it’s over 6%. It’s going take a bit to go from six to two. The uncertainty now is about how much more front-loading they’re going to do? When we hit the terminal rate? And when will that happen?
What is terminal rate? Terminal rate is the rate by which the rate hikes will end, they won’t go any further. Nobody really knows when the terminal rate will occur. We can guess. We’re now looking at the end-of-the-year rate, not the terminal rate, but end of year rate in the 425 to 450 basis point range. That’s a lot, from 25 basis point and zero when we first started at the beginning of the year. That’s a lot of front-loading. And we still do not see the terminal rate in sight.
We were bending and now we are thinking it’s going to break. And what do we mean by the economy breaking?
Number one, we strongly believe it’s going to be a “hard landing.”
Meaning that we will end up in a recession. And of course, the Fed doesn’t say aloud it’s okay to be in a recession, but the Fed has signaled very clearly that it’s going to inflict a little bit of pain to end inflation. Well, what is pain? Recession is pain, right? The Fed’s actions lead us to believe they are engineering the following two things:
- The Fed is willing to put up with a little bit of pain to get inflation down. They also understand pain to include lower economic activity, lower aggregate demand, meaning lower GDP.
- The Fed also understands there is a mismatch between the supply of labor and the need for labor, the demand for labor. The mismatch exists in the sense there’s too much demand, not enough supply.
Now, we’re not gonna get into all those reasons, but some of the reasons are obvious that just some people have made a definitive change and quit. The age of Great Resignation, if you remember that term, from two quarters ago. In order to bring that balance The Fed will slow the economy, so businesses will want to hire fewer people and match the supply. So we are also thinking what The Fed is talking about increasing unemployment rate, right?
So, increased unemployment and lower economic activity – all that sounds awfully like a recession.
But that’s not the only thing that’s breaking.
Number two, we can see looking at the United Kingdom, for example, their currency has broken.
Their long-term bonds have spiked the interest rate. In other words, investors are expecting a much higher cost of borrowing, which affects everything. For example, in the case of United Kingdom, this affects their pension plan, which have a certain type of scheme that requires an interest rate to be more stable and lower because they were – they and us and the whole world – used to a low interest rate environment.
Bend has been happening, but break we believe is going to happen.
The question is, what kind of breakage and will there be spillover effects? All that is yet unknown.
I think 2023 will be even more challenging, as we stand here or sit here in the final quarter of 2022. There will be more interest rate hikes. We are currently sitting around 425. Yet, we are probably looking at another 75 to 100 basis point to go from the end of this year, leaving us at 500 to 525.
Click any image above to view a larger version of the table.
That is really meaningful.
If we can barely afford our homes, to buy homes now at a six plus percent mortgage rate, we are not likely to be able to afford it at seven plus or eight plus percent mortgage rate. These are things that affect real life, that affects all of us.
Finally, of course, this has been a credit-driven excited economy ever since the global financial crisis, making interest rates very low, making us all want to take risks, make us all want to go borrow and spend, make our balance sheet much more debt-driven.
That is going to hurt us. When interest goes up, the cost of servicing our debt has just ratcheted up.
With all of those things are happening, it’s hard to envision that it will be smooth. We believe it is not going to be okay.